What Exactly Is Earnings Growth?

“When a mutual fund manager states that he looks at a company’s earnings growth when valuing a stock, what generally (or exactly) is he looking at and how can I get access to this info. It seems that it would be either projections and guesswork or hindsight and old news.” — Mitch Hagens

Well, you’re right. Indeed, all too often it’s both: guesswork based on old news.

But let me back up a minute. In theory, a company’s value is based on two things: its future earnings and the value of any assets that might not be needed to produce those earnings. A company that earns $1 million a year, and always will, never more, never less, might be valued in today’s interest-rate environment at, say, $12 million — 12 times earnings. If it also owned a $3 million art collection that had nothing to do with the widgets it made, and could be sold off without hurting earnings, then the company would be worth $15 million — the $12 million from its earning power plus the $3 million from the art collection. If it’s divided into a million shares, you might consider them a bargain if they were selling for $7 each, say; way overpriced if they were selling for $29.

The actual price today’s market might pay for such a company would depend on things like what proportion of its $1 million earnings was paid out in dividends each year, how certain everyone was that the earnings would never rise or fall, and what chance they’d have of persuading management to sell the art collection. And on and on.

In reality, no company can guarantee future earnings. It’s a matter of projection. So whatever you (and the market as a whole) might pay for the company I just described will depend in no small measure on two things. First, our guess as to how fast earnings will grow, if at all; second, what underutilized assets might be hiding on the balance sheet.

Clearly, a company whose profits are likely to grow 30% a year for the foreseeable future (because they have a patent on some great new cellular phone and everyone is dying to have one?) is more valuable than a company with equal profits — today — but no prospect of appreciable growth (because they make thumbtacks, and nothing seems to be changing their business very much).

As a practical matter, in looking at earnings growth, mutual fund managers look at past growth (as you say: old news), at management’s stated objectives and projections (guesswork at best), and at the research reports of “sell side” analysts employed by Wall Street brokerage firms like Merrill Lynch, Morgan Stanley and Goldman Sachs, among many, many others.

(Mutual funds managers are on the “buy side,” because they’re in the driver’s seat. They get to decide which brokerage house ideas to buy and whom to favor with their business. They’re the customer: they get to scream at brokers. Brokers never get to scream at money managers — only after they hang up the phone. They’re on the “sell side,” because they hope to sell clients on using them to make trades. One way they do it: providing research.)

Wall Street analysts (and some conscientious mutual fund managers) will look at a host of things in trying to predict future earnings growth. For example, they might check out demographic trends to see how many young families are likely to be buying homes and what effect that might have on the sales of kitchen appliances. They might try to know an industry so well as to be able to have a feel for which management teams are strongest, which competitive strategies most likely to succeed — and how all this will affect market shares, sales growth and profits. They might consult biochemists to assess the prospects for a particular hoped-for breakthrough, interview customers to get a sense of future purchasing plans . . . all sorts of things.

Yet when all is said and done, because there are SO many variables, the earnings projections of Wall Street’s best respected analysts are notoriously unreliable. They tend to project that past growth rates will continue into the future until management cautions otherwise, at which point they begin projecting something else.

For what it’s worth, Wall Street research is available almost instantly to mutual fund managers and almost anyone else willing to pay for it via services like the “Bloomberg” terminals money managers have on their desks — yours for about $18,000 a year — and services like First Call, which are an almost instant way to get research analysis from the Wall Street houses with which your institution does business. What’s that? You’re not an institution? Well, a lot of this probably won’t be available to you. But for the long-term investor, I’m not sure the lack of these resources is such a handicap.

The stock market is a tough, tough game, because as hard as it is to guess at future earnings, that’s only part of the job. You then have to consider the degree to which those prospects are already “in” the price of the stock. If most people agree with your earnings assessment, the price of the stock will already reflect that and thus be no bargain.

I’ve been going around interviewing hugely successful money managers for a PBS series Jane Bryant Quinn and I will be hosting in the fall (BEYOND WALL STREET: The Art of Investing). If I had to summarize what impresses me most about them, besides the occasional Monet or Renoir hanging on their walls, it would be two things. First, that a rare few people can do appreciably better than the relevant market averages over the long term — it’s not all luck as “efficient market” purists believe. But second — at least if you’re managing large sums of money — it takes tremendous dedication. These people really do their homework.